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Finance professor Jeffrey R. Brown also is the director of the Center for Business and Public Policy in the College of Business.

Photo courtesy of the College of Business

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After last week's Standard & Poor's credit downgrade, Illinois now has the lowest credit rating among the 50 states. In demoting the Land of Lincoln to a notch below California, S&P signaled that further downgrades were possible given the state's inability to rein in its $96 billion mountain of pension debt.

In an interview with News Bureau business and law editor Phil Ciciora, finance professor Jeffrey R. Brown, who's also the director of the Center for Business and Public Policy in the College of Business and was a senior economist with the President's Council of Economic Advisers from 2001-2002, discusses Illinois' pension predicament.

The estimated shortfall of the state pension system has been pegged as high as $100 billion - and that's using the most generous of accounting tricks. How much does the state really owe?

According to government accounting standards, the state of Illinois is approximately $96 billion short of the money required to pay the benefits that have already been promised. In reality, the shortfall is at least two to three times that large. The basic problem is that the government accounting standards allow public pensions to pretend as if they will generate returns of nearly 8 percent forever without taking on any risk. This is, of course, completely unrealistic.

Indeed, one would have to search far and wide to find a reputable financial economist - of any political persuasion or ideology - who believes that this particular public pension accounting rule has any reasonable intellectual foundation. This is fundamentally an issue of appropriate financial measurement and we have a very good idea what the right answer is.

Unfortunately, government accounting rules do not reflect this body of knowledge. Instead, the rules are a political compromise that arise out of some combination of, first, a lack of understanding of how to account for risk when valuing future cash flows, and, second, an apparent concern that defined benefit plans may be more difficult to sustain politically if taxpayers understood the full economic cost. So, sadly, an issue of appropriate measurement has become politicized, and a severely flawed measure has found its way into official accounting rules.

Pension reform is proving to be the Gordian knot of Illinois politics. Is a fully funded pension system simply just an impossibility at this point, from both a political and a fiscal standpoint?

This problem has been many decades in the making, and it is not economically or politically realistic to think that it will be solved over a short period of time.

Fortunately, although full funding would be a great outcome, it is not strictly necessary. A government - unlike a corporation - can choose to transfer resources across generations through fiscal policy. The state of Illinois has chosen to effectively borrow several hundred billion dollars from future generations by underfunding public pensions. This has allowed the state to keep taxes artificially low and spending unsustainably high for several generations. What we are now experiencing is that such an approach to fiscal policy eventually comes at a high cost. Ultimately, too much debt - either to bondholders or to pensioners - generates so much fiscal overhang that it begins to crowd out everything else we may wish to do.

That time has come in Illinois. Our past fiscal indiscretions are now putting enormous financial pressure on our state. Even with a 67 percent increase in tax rates (from 3 to 5 percent on individuals), we are still facing a huge fiscal hole. As a result, other public services - including K-12 and higher education in Illinois - are paying the price.

I think the best we can hope for is that, through a combination of benefit changes, other spending reductions, revenue increases and funding discipline, we can get the state of Illinois onto a fiscally and politically sustainable path. This does not have to mean full funding, but it does mean that we have to at least return ourselves to a path where our pensions are funded enough so that pensioners have a secure benefit and that the share of state GDP that is being consumed by pension funding is something the state can afford. This will require a sharp break with the past on many dimensions. But if we continue to act in the future like we have acted in the past, we will not succeed.

Experts say that Illinois now faces the worst pension mess in the country - but we're certainly not the only state with an unfunded pension system. Is a federal bailout of states' pension debt a viable option?

One thing I have learned over the years from my involvement with federal policymaking is that one should never say never.

However, I think it is unlikely. Although many states have problems, there is enormous variation in the size of the shortfall. What makes one think that senators and representatives from states that have responsibly managed their public pensions will want to bailout those states that have utterly failed at engaging in responsible fiscal management? Sure, you may get Illinois and California delegations to support it, but it is hard to see one's way to a majority, especially in the U.S. Senate, where big states like California and Illinois only have two votes each.

The state income tax rate is scheduled to drop from 5 to 3.75 percent in 2015. Can the state afford to let that happen? What other revenue enhancers should be considered - taxing retirement benefits? more gambling revenue? a special pension surcharge tax?

This state's fiscal hole is so large that even with the 5 percent income tax in place, we are unable to balance our budget without borrowing, either by issuing bonds or underfunding our pensions. That problem is not going to magically go away by 2015, so it is hard to see how we could allow the tax rates to decline without undertaking truly unprecedented spending reductions. If we continue to spend at anything near current levels, fail to reform pensions, and let the tax rates decline, then our deficits would explode.

As one small piece of an overall solution, I have proposed in a white paper co-written with several colleagues from the (U. of I.) Institute of Government and Public Affairs that we end the state income tax exemption on retirement income in Illinois. We are one of only a small number of states that have such an exemption, and there is not a very compelling economic rationale for it.